Money for life: 3 secrets to financial success

This is the first in an occasional series titled “Money For Life,” based on live panel discussions with experts and financial advisers on how to have the richest financial life. In this segment, the focus is financial concepts and actionable ideas for millennials.

It won’t take much for you to be successful with your money. But it will require learning three basic financial concepts. Yes, to improve your odds of building a large nest egg for retirement or earning as much money as possible over the course of your lifetime, you’ve got to get a handle on compound interest, inflation, and risk diversification.

In a later installment, we’ll discuss two other important financial concepts – the tax treatment of retirement accounts, and how employer matches in defined-contribution plans.

The power of compounding

So, what do you need to know about compounding? Simply this: If you set aside $30,000 when you’re 18 and your money earns 7% or so per year you’ll be a millionaire by the time you’re 68. “That’s the power of compounding,” said John Pelletier, the director of the Center for Financial Literacy at Champlain College in Burlington, Vt. and one of four panelists. “It’s the interest on your interest.”

And the longer your money can earn interest on the interest, the more you’ll have.

To be sure, it might be hard to understand that today when banks don’t pay much more than 1% on savings.

“But if you invest for the long term in stocks and bonds in a nice diversified portfolio you can get 7%,” said Pelletier, who was joined on the panel by Robert Glovsky, a certified financial planner and vice chair of the Colony Group in Boston, Mass.; Eleanor Blayney, a certified financial planner and consumer advocate for the Certified Financial Planner Board of Standards in Washington, D.C.; and Catey Hill, a personal finance reporter for MarketWatch in New York City.

You can use the rule of 72 to learn about the power of compounding. That rule tells you how many years it will take to double your money given a certain interest rate. The formula is simple; It’s 72 divided by the interest rate. And the answer is how long it takes to double your money.

So, at 6% interest, your money would double in 12 years (72/6). To double your money in 10 years, you would need to earn 7.2% (72/10). And if interest rates are 2%, it would take 36 years to double your money (72/2). You get the picture.

One example that speaks to the power of compounding, according to Glovsky, is this: If you set aside $1,000 per year for 10 years from ages 25 to 35 and it compounded till age 65, you’d have more money set aside than if you started at age 35 and saved $1,000 for 30 years. “It’s the power of saving early and compounding is what really wins for you,” he said.

Blayney pointed out that saving in a tax-deferred retirement account such as a 401(k) or IRA is an especially great way to take advantage of the power of compounding. Money in those accounts grows tax-free — unlike money in taxable accounts where interest income, dividends and capital gains would be taxed at ordinary income rates. “So we add a little more hot sauce” to the miracle of compounding, said Blayney. It’s going to grow and compound without being taxed as it compounds.

Inflation and the loss of purchasing power

Another financial planning concept has to do with inflation, that’s the concept that the price of goods and services increases over time. And the reason why it’s important to learn about inflation is that you want to always remember the risk that comes with inflation: the risk of purchasing power.

Consider: A suitcase of beer today costs about $15. And if inflation runs a 3% over the next 20 years, it will cost about $30 to buy that same suitcase. Or if you take the same dollars, $15, you’d only be able to buy a six-pack. And that’s the effect of inflation on money. Things either cost more or you’ll purchase less.

During the panel discussion, Pelletier said it’s wise to think inflation with respect to your investments and the difference real and nominal returns. Nominal returns would be the gross amount that you earn on your money. Real returns would be the net amount you earn after factoring in inflation.

So, for instance, if you currently earn 1% on your money in a savings account and inflation is 2%, your real rate of return would be negative 1% (-1) at the end of one year. “At the end of a year do you have more money or less money?” Pelletier asked college students attending the panel discussion. “You actually have less because it’s going to cost you more to buy what you wanted to buy than you actually have with your savings.”

Pelletier suggested that savings accounts are perfectly fine to use for emergency funds and short-term goals, a down payment on a car or house for instance. But money earmarked for long-term goals, such as retirement, should be placed in investments — such as a target-date retirement fund — that provide the potential to beat inflation.

By how much should your investments outpace inflation? Pelletier recommending using this rule of thumb: “Beat inflation on an after-tax basis by 3% every single year and you’ll be fine,” he said.

Pelletier also said inflation is important to consider when you’re in the workforce and trying to evaluate salary increases. If you get a raise, you’ll want to determine if it’s a good raise. One way to figure that out is to determine whether your purchasing power actually increased. “Can (you) actually buy more stuff with the money somebody’s paying me?” asked Pelletier. “And if (you) can’t, maybe it’s not a good raise.”

An easier way to determine if it’s a good raise or not, is to look at the percent increase. If inflation is 4% and you get a 2% pay raise, you’ve lost purchasing power. “That’s not a good raise,” said Pelletier. “Under that scenario 4% would just keep you equal to the same lifestyle you have today. A good raise would be maybe 5%.”

So, if nothing else, one reason why you might want to pay attention to the inflation rate is to understand every year you’re getting a raise whether you are actually getting more money, said Pelletier. “By that I mean purchasing power money, that (you) can use to buy additional goods and services or safe with or pay off bills with.”

Risk diversification

According to the panelists, investing in stocks is one way to keep pace or outpace inflation. But investing in stocks also means that you have to develop an understanding of risk, and the importance of yet another concept: diversification.

In essence, diversification means not putting all your eggs in one basket. It means, in the jargon of investment professionals, reducing non-systemic risk by investing in a variety of assets — stocks, bonds, cash and so on. “If you think about these three different classes, they work together to lower the risk because they don’t work together,” said Pelletier. “And then if you think about then each bucket within each class, they work together because they help to spread the volatility or the diversification. And we’re always talking about volatility and volatility is risk.”

Stocks tend to be more volatile than bonds. And bonds tend to be more volatile than cash.

In the real world, however, young workers often make a common diversification mistake when investing in their 401(k). They invest using something called 1/n; they invest equal amounts of money in however many mutual funds are offered in their 401(k) plan.

So if there are 10 funds, they invest 1/10th of their total contribution across all 10 funds without regard for whether it makes sense or not. But that’s not necessarily diversification; that’s spaghetti against the wall. A better approach for young workers would be invest most if not all of their money in their 401(k) in a target date fund. Those funds invest in a mix of stocks, bonds, and cash based on the investor’s anticipated year of retirement.

“So my bottom line when you’re going into a 401(k) plan is pick a target fund,” said Pelletier. “Now it may not be perfect and we can nitpick at it but for, I don’t know, I don’t want to say 90%, but for the vast majority of Americans that don’t study this stuff all the time, pick a target fund.”

Pelletier added: And fundamentally you think about it as if you’re 50 years away from retirement, then you can afford to be really aggressive today. And maybe when you get to be 65 or 70 you want to be a little less aggressive. The target fund scales itself down over that period of time. So you’re starting off with a fund that’s very aggressive. It’s a fund of funds. It’s got all these underlying different areas in it that we just talked about. And you don’t have to worry about doing any of the research.”

At a minimum, Pelletier advised young Americans who are saving for retirement to avoid investing in low-volatility investments. “What do most people do?” he asked. “They go into the money market fund, which is the lowest-yielding, lowest-returning product and lousy for you ‘cause you’re losing to inflation over a long period of time. So I strongly urge you to do the target fund that’s got the longest maturity out there and then just forget about it, keep adding to it. That’s my take away.”

Blayney suggested that young workers consider investing outside their 401(k) plans, in mutual funds, which can provide “instance diversification.”

The panelists did note, however, that investing in a Standard & Poor’s 500
SPX, +0.04%
stock only doesn’t mean that you are properly diversified. It means you’ll be diversified among large capitalization stocks. But that sort of investments means that you haven’t invested in small-cap growth or small-cap value funds or bonds or international stocks.

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